The global financial crisis has led to a profound rethinking of the consensus on monetary policy. Before the crisis, most monetary economists agreed that "flexible inflation targeting"—in which cent ...

The global financial crisis has led to a profound rethinking of the consensus on monetary policy. Before the crisis, most monetary economists agreed that "flexible inflation targeting"—in which central banks focus on maintaining price stability and stabilizing the output gap—was an appropriate and sufficient mandate for conducting monetary policy. Key assumptions underlying the consensus were that this mandate would automatically lead to financial stability and that the framework of monetary policy could deal with cross-border capital flows.

The global financial crisis has made central banks in the advanced economies “rediscover” the importance of financial stability. In the emerging market economies, in contrast, central banks have always regarded financial stability as one of their central responsibilities. In fact, a number of monetary policy instruments now called “heterodox” or “non conventional” in the context of the advanced economies, have been utilized for decades by central banks in emerging markets (e.g., liquidity or reserve requirements).

The recurrent episodes of financial turbulence forced central banks in emerging markets to focus on financial stability, while in the advanced economies (under the influence of the great moderation) monetary theory and practice drifted towards the view that central banks should focus only on price stability, and set an inflation target in the context of a transparent and predictable policy framework. According to this view, central banks should rely on interest rates as the only instrument, without resorting to foreign exchange intervention or quantitative targets. In this process, financial regulation and supervision were increasingly separated from the conduct of monetary policy (e.g., in the UK and in the Eurozone).

The global financial crisis has shown that this view was wrong. Advanced central banks have been forced by the crisis to change the way they carried out monetary policy, and financial stability has been brought back to their core set of responsibilities. But this change will imply significant institutional challenges in the future, most notably at the ECB.

What are the principles that should guide institutional changes at central banks following what we have learned from the global financial crisis?

First, a strict inflation target may not always be optimal. A fixed inflation target may be desirable under conditions of low volatility. Under exceptional situations of high volatility, be it because of financial or real shocks, central banks should adopt a more flexible inflation target that may need to be made contingent on the state of nature.

Second, central banks need to define more precisely the relevant concept of liquidity for the formulation of monetary policy. Liquidity may exceed the conventional definitions of money aggregates, as innovations in the capital market expand the notion of liquid (or safe) assets well beyond the banking system. Hence, central banks may need to use tools such as quantitative easing and foreign exchange intervention (e.g., currency swaps among central banks) in addition to short-term interest rates in the conduct of monetary policy.

Third, if the relevant concept of liquidity includes assets issued and traded in the shadow banking system or in the capital market, then central banks should have the mandate to regulate and intervene in those markets.

Fourth, as regards financial stability and its implications for central banks, two important dimensions should be clearly recognized: 1) prevention or, more specifically, prudential regulation, and 2) crisis management.

b) as the creation liquid assets extends beyond the conventional boundaries of a financial system, central banks should be able to extend their regulatory mandate to the same domain in which they act as providers of liquidity; credit provision in the economy is tightly linked to the presence of liquid collateral.

c) Basel III has correctly introduced new liquidity requirements on banks, but the fact that those requirements may be met with government bonds may turn out to counterproductive in many instances:

d) Capital and liquidity requirements should be higher in large banks with significant cross-border activities, as systemic risk and the probability of contagion is larger;

e) Significant cross-border banking presence needs to be complemented by a clear international coordination of the lender-of-last-resort function among central banks (currency swaps among central banks).

Even if a sound financial regulation is put in place, financial crises may (and will) occur. In such circumstances, central banks have to deal with crisis management. A general lesson from the current global financial crisis (as well as from many banking crises occurred in the past in emerging markets) is that central banks are forced to resort to new instruments and often have to take unprecedented actions that exceed their normal policy framework. Hence, the legal framework applying to central banks, while being strict in normal times in order to avoid discretion, should explicitly contemplate crisis situations where significant flexibility should be allowed in terms of the actions and policies that central banks may find appropriate to contain systemic risk.

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